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Chapter 14
The Money
Supply Process
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Players in the Money Supply
Process
• Central bank (Federal Reserve System)
• Banks (depository institutions; financial
intermediaries)
• Depositors (individuals and institutions)
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14-2
Fed’s Balance Sheet
Federal Reserve System
Assets
Liabilities
Government securities
Currency in circulation
Discount loans
Reserves
• Monetary Liabilities
– Currency in circulation: in the hands of the public
– Reserves: bank deposits at the Fed and vault cash
• Assets
– Government securities: holdings by the Fed that affect
money supply and earn interest
– Discount loans: provide reserves to banks and earn
the discount rate
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14-3
Monetary Base
High-powered money
MB = C + R
C = currency in circulation
R = total reserves in the banking system
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14-4
Open Market Purchase from
a Bank
Banking System
Assets
Liabilities
Securities
-$100
Reserves
+$100
Federal Reserve System
Assets
Securities
Liabilities
+$100 Reserves
+$100
• Net result is that reserves have increased by $100
• No change in currency
• Monetary base has risen by $100
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14-5
Open Market Purchase from
Nonbank Public I
Banking System
Assets
Reserves
Federal Reserve System
Liabilities
+$100 Checkable
deposits
+$100
Assets
Securities
Liabilities
+$100 Reserves
+$100
• Person selling bonds to the Fed deposits the Fed’s
check in the bank
• Identical result as the purchase from a bank
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14-6
Open Market Purchase from
Nonbank Public II
Nonbank Public
Assets
Liabilities
Securities
-$100
Currency
+$100
Federal Reserve System
Assets
Securities
Liabilities
+$100 Currency in
circulation
+$100
• The person selling the bonds cashes the Fed’s check
• Reserves are unchanged
• Currency in circulation increases by the amount of
the open market purchase
• Monetary base increases by the amount of the open
market purchase
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14-7
Open Market Purchase:
Summary
• The effect of an open market purchase on
reserves depends on whether the seller of
the bonds keeps the proceeds from the sale
in currency or in deposits
• The effect of an open market purchase on
the monetary base always increases the
monetary base by the amount of the
purchase
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14-8
Open Market Sale
Nonbank Public
Assets
Liabilities
Securities
+$100
Currency
-$100
Federal Reserve System
Assets
Securities
Liabilities
-$100 Currency in
circulation
-$100
• Reduces the monetary base by the amount of
the sale
• Reserves remain unchanged
• The effect of open market operations on the
monetary base is much more certain than the
effect on reserves
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14-9
Shifts from Deposits into
Currency
Nonbank Public
Assets
Banking System
Liabilities
Checkable
deposits
-$100
Currency
+$100
Assets
Reserves
Federal Reserve System
Assets
Liabilities
Currency in
circulation
+$100
Reserves
-$100
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Liabilities
-$100 Checkable
deposits
-$100
Net effect
on monetary liabilities
is zero
Reserves are changed
by random fluctuations
Monetary base
is a more stable variable
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Making a Discount Loan to a
Bank
Banking System
Assets
Reserves
Federal Reserve System
Liabilities
+$100 Discount
loans
+$100
(borrowing from Fed)
Assets
Discount
loan
Liabilities
+$100 Reserves
+$100
(borrowing from
Fed)
• Monetary liabilities of the Fed have increased by
$100
• Monetary base also increases by this amount
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14-11
Paying Off a Discount Loan
from the Fed
Banking System
Assets
Reserves
Federal Reserve System
Liabilities
-$100 Discount
loans
-$100
(borrowing from Fed)
Assets
Discount
loans
Liabilities
-$100 Reserves
-$100
(borrowing from
Fed)
• Net effect on monetary base is a reduction
• Monetary base changes one-for-one with a change
in the borrowings from the Federal Reserve System
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14-12
Other Factors Affecting the
Monetary Base
• Float
• Treasury deposits at the Federal Reserve
• Interventions in the foreign exchange
market
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14-13
Fed’s Ability to Control the
Monetary Base
• Open market operations are controlled by the Fed
• The Fed cannot determine the amount of
borrowing by banks from the Fed
• Split the monetary base into two components
MBn= MB - BR
• The money supply is positively related to both the
non-borrowed monetary base MBn and
to the level of borrowed reserves, BR, from
the Fed
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14-14
Deposit Creation: Single
Bank
First National Bank
Assets
First National Bank
Liabilities
Assets
Liabilities
Securities
-$100
Securities
-$100 Checkable
deposits
Reserves
+$100
Reserves
+$100
Loans
+$100
First National Bank
Assets
Liabilities
Securities
-$100
Loans
+$100
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+$100
Excess reserves increase
Bank loans out the excess reserves
Creates a checking account
Borrower makes purchases
The money supply has increased
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Deposit Creation:
The Banking System
Bank A
Assets
Reserves
Bank A
Liabilities
+$100 Checkable
deposits
Assets
+$100 Reserves
Loans
Reserves
+$100
Bank B
Liabilities
+$90 Checkable
deposits
Assets
+$90 Reserves
Loans
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+$10 Checkable
deposits
+$90
Bank B
Assets
Liabilities
Liabilities
+$9 Checkable
deposits
+$90
+$81
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Table 1 Creation of Deposits (assuming
10% reserve requirement and a $100
increase in reserves)
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The Formula for Multiple
Deposit Creation
Assuming banks do not hold excess reserves
Required Reserves (RR) = Total Reserves (R)
RR = Required Reserve Ratio (r ) times the total amount
of checkable deposits (D)
Substituting
r × D=R
Dividing both sides by r
1
D= × R
r
Taking the change in both sides yields
1
∆D = × ∆R
r
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14-18
Critique of the Simple Model
• Holding cash stops the process
– Currency has no multiple deposit expansion
• Banks may not use all of their excess
reserves to buy securities or make loans.
• Depositors’ decisions (how much currency to
hold) and bank’s decisions (amount of
excess reserves to hold) also cause the
money supply to change.
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14-19
Factors that Determine the
Money Supply
• Changes in the nonborrowed monetary base
MBn
– The money supply is positively related to the
non-borrowed monetary base MBn
• Changes in borrowed reserves from the Fed
– The money supply is positively related to the
level of borrowed reserves, BR, from the Fed
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14-20
Factors that Determine the
Money Supply
• Changes in the required reserves ratio
– The money supply is negatively related to the
required reserve ratio.
• Changes in currency holdings
– The money supply is negatively related to
currency holdings.
• Changes in excess reserves
– The money supply is negatively related to the
amount of excess reserves.
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14-21
Summary Table 1 Money Supply
Response
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14-22
The Money Multiplier
• Define money as currency plus checkable
deposits: M1
• Link the money supply (M) to the monetary
base (MB) and let m be the money multiplier
M= m × MB
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14-23
Deriving the
Money Multiplier I
Assume that the desired holdings of currency C and
excess reserves ER grow proportionally with checkable
deposits D. Then,
c = {C/D} = currency ratio
e = {ER/D} = excess reserves ratio
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14-24
Deriving the
Money Multiplier II
The total amount of reserves (R) equals the sum of
required reserves (RR) and excess reserves (ER).
R = RR + ER
The total amount of required reserves equals the required
reserve ratio times the amount of checkable deposits
RR = r * D
Subsituting for RR in the first equation
R = (r * D) + ER
The Fed sets r to less than 1
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14-25
Deriving the
Money Multiplier III
• The monetary base MB equals currency (C)
plus reserves (R):
MB = C + R = C + (r x D) + ER
• Equation reveals the amount of the
monetary base needed to support the
existing amounts of checkable deposits,
currency and excess reserves.
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14-26
Deriving the
Money Multiplier IV
c = {C / D} ⇒ C = c × D and
e = {ER / D} ⇒ ER = e × D
Substituting in the previous equation
MB = (r × D) + (e × D) + (c × D) = (r + e + c) × D
Divide both sides by the term in parentheses
1
× MB
D=
r +e+c
M = D + C and C = c × D
M = D + (c × D) = (1+ c) × D
Substituting again
1+ c
M=
× MB
r +e+c
The money multiplier is then
1+ c
m=
r +e+c
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14-27
Intuition Behind the
Money Multiplier
r = required reserve ratio = 0.10
C = currency in circulation = $400B
D = checkable deposits = $800B
ER = excess reserves = $0.8B
M = money supply (M1) = C + D = $1,200B
$400B
= 0.5
$800B
$0.8B
= 0.001
e=
$800B
1.5
1+ 0.5
=
= 2.5
m=
0.1+ 0.001+ 0.5 0.601
This is less than the simple deposit multiplier
Although there is multiple expansion of deposits,
there is no such expansion for currency
c=
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14-28
Application: The Great Depression
Bank Panics, 1930 - 1933.
• Bank failures (and no deposit insurance)
determined:
– Increase in deposit outflows and holding of
currency (depositors)
– An increase in the amount of excess reserves
(banks)
• For a relatively constant MB, the money
supply decreased due to the fall of the
money multiplier.
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14-29
FIGURE 1 Deposits of Failed
Commercial Banks, 1929–1933
Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United
States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963), p. 309.
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14-30
FIGURE 2 Excess Reserves Ratio
and Currency Ratio, 1929–1933
Sources: Federal Reserve Bulletin; Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–
1960 (Princeton, NJ: Princeton University Press, 1963), p. 333.
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14-31
FIGURE 3 M1 and the Monetary
Base, 1929–1933
Source: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960
(Princeton, NJ: Princeton University Press, 1963), p. 333.
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